Unlike a share of stock, a bond or other debt security has a specified date on which it matures. On its maturity date, the principal (also called the “face amount”) is paid to investors. In the meantime, interest equal to a specified percentage of the principal is paid to investors on specified interest dates. Think of the principal and interest payments of the bond as a stream of cash flows that an investor will receive in exchange for purchasing the bond. The investor values that stream of cash flows using the prevailing market interest rate for debt of similar risk and maturity. If the interest rate paid by the bond (the “stated rate”) is higher than the market rate, the bond can be sold for more than its maturity value (so it is “sold at a premium”). If the stated rate is lower than the market rate, the bond must be sold for less than its maturity value (so it is “sold at a discount”). For an example of valuing a bond, see Illustration 12-1.
The fair value of a bond changes when market interest rates change. If market rates of interest rise after a fixed-rate security is purchased, the value of the fixed-interest payments declines. So, the fair value of the investment falls. Conversely, if market rates of interest fall after a fixed-rate security is purchased, the fixed interest payments become relatively more attractive, so the fair value of the investment rises.
Increases and decreases in fair value between the day a debt security is acquired and the day it matures to a prearranged maturity value are less important if sale before maturity isn't an alternative. For this reason, if an investor has the “positive intent and ability” to hold the securities to maturity, investments in debt securities can be classified as held-to-maturity (HTM) and reported at their amortized cost in the balance sheet.1 A debt security cannot be classified as held-to-maturity if the investor might sell it before maturity in response to changes in market prices or interest rates, to meet the investor's liquidity needs, or similar factors.
Let's use the bond from Illustration 12-1 to see how we account for an investment in held-to-maturity debt securities.
The market value of a fixed-rate investment moves in the opposite direction of market rates of interest.
Changes in market value are less relevant to an investor who will hold a security to its maturity regardless of those changes.
Bonds Purchased at a Discount
Because interest is paid semiannually, the present value calculations use:
a. one-half the stated rate (6%),
b. one-half the market rate (7%), and
c. 6 (=3 × 2) semiannual periods.
On July 1, 2011, Masterwear Industries issued $700,000 of 12% bonds, dated July 1. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years, on June 30, 2014. The market interest rate for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup, Inc.*
* The numbers in this illustration are the same as those in Illustration 14-2 in chapter 14 (except for some differences in dates between the two chapters). This helps us to better appreciate in chapter 14 how Masterwear's accounting for its bond liability to United compares to United's accounting for its investment in Masterwear bonds. You can find an explanation of why we calculate the bond price this way on pages 750 and 751.
** Present value of an ordinary annuity of $1: n = 6, i = 7% (Table 4, at the back of the book).
† Present value of $1: n = 6, i = 7% (Table 2, at the back of the book).
Note: Present value tables are provided at the end of this textbook. If you need to review the concept of the time value of money, refer to the discussions in Chapter 6.
PURCHASE OF INVESTMENT. The journal entry to record the purchase of the HTM investments is:
All investment securities are initially recorded at cost.
Discount on bond investment is a contra-asset to the investment in bonds asset account that serves to reduce the carrying value of the bond asset to its cost at the date of purchase.
RECOGNIZE INVESTMENT REVENUE. The Masterwear bonds pay cash interest at a rate of 12%, but were issued at a time when the market rate of interest was 14%. As a result, the bonds were sold at a discount that was large enough to provide bond purchasers with the same effective rate of return on their investment (14%) that they could get elsewhere in the market. Think of it this way: a little piece of that initial discount serves each period to make up the difference between the relatively low rate of interest that the bond pays (12%) and the higher rate of interest that the market demands (14%). Recording interest each period as the effective market rate of interest multiplied by the outstanding balance of the investment is referred to as the effective interest method. This simply is an application of the accrual concept, consistent with accruing all revenues as they are earned, regardless of when cash is received.
The effective interest on debt is the market rate of interest multiplied by the outstanding balance of the debt.
Continuing our example, the initial investment is $666,633. Since the effective interest rate is 14%, interest recorded as revenue to the investor for the first six-month interest period is $46,664:
However, the bond calls for semiannual interest payments of only $42,000—the stated rate (6%) times the face amount ($700,000). As always, when only a portion of revenue is received, the remainder becomes an asset—in this case an addition to the existing investment. So the difference, $4,664, increases the investment by reducing the discount to $28,703 ($33,367 − 4,664). The journal entry to record the interest received for the first six months as investment revenue is:
The amortized cost of the investment now is $700,000 − $28,703 = $671,297.
Graphic 12-4 demonstrates interest being recorded at the effective rate over the life of this investment. As you can see, the amortization of discount gradually increases the carrying value of the investment, until the investment reaches its face amount of $700,000 at the time when the debt matures.
We discuss accounting for discounts and premiums in much greater detail in Chapter 14.
If a bond is purchased at a discount, less cash is received each period than the effective interest, so the unpaid difference increases the outstanding balance of the investment.
Suppose the bonds are not traded on an active exchange. How would you determine the fair value of the Masterwear bonds on December 31, 2011? Recall from Chapter 1 that GAAP identifies different ways that a firm can determine fair value. If the Masterwear bonds are publicly traded, United can find the fair value by looking up the current market price (this way of obtaining fair value is consistent with “level one” of the fair value hierarchy). On the other hand, if the bonds are not publicly traded, United can calculate the fair value by using the present value techniques shown in Illustration 12-1 (this way of obtaining fair value is consistent with “level two” of the fair value hierarchy). With five interest periods remaining, and a current market rate of 11% (5.5% semi-annually), the present value would be $714,943:
*Present value of an ordinary annuity of $1: n = 5, i = 5.5%. (Table 4)
†Present value of $1: n = 5, i = 5.5%. (Table 2)
SELL HTM INVESTMENTS. Typically, held-to-maturity investments are—you guessed it—held to maturity. However, suppose that due to unforeseen circumstances the company decided to sell its debt investment for $725,000 on January 15, 2012.4 United would record the sale as follows (for simplicity we ignore any interest earned during 2012): (K)
In other words, United would record this sale just like any other asset sale, with a gain or loss determined by comparing the cash received with the carrying value (in this case, the amortized cost) of the asset given up.
We will revisit our discussion of investments in debt securities to be “held to maturity” in Chapter 14, “Bonds and Long-Term Notes.” This way we can more readily see that accounting by the company that issues bonds and by the company that invests in those bonds is opposite but parallel; that is, each side of the transaction is the mirror image of the other.
Obviously, not all investments are intended to be held to maturity. When an investment is acquired to be held for an unspecified period of time, we classify the investment as either (a) “trading securities” or (b) “securities available-for-sale.” These include investments in debt securities that are not classified as held-to-maturity and equity securities that have readily determinable fair values. You'll notice that, unlike held-to-maturity securities, we report investments in the other two categories at their fair values.
1FASB ASC 320–10–25–1: Investments–Debt and Equity Securities–Overall–Recognition (previously “Accounting for Certain Investments in Debt and Equity Securities,” Statement of Financial Accounting Standards No. 115 (Norwalk, Conn.: FASB, 1993)).
2If an unrealized loss from holding an HTM investment is not viewed as temporary, an “other-than-temporary impairment” (OTT impairment) may have to be recorded. We discuss OTT impairments in more detail in Appendix 12B.
3If United had chosen the fair value option for this investment, it would classify the investment as a trading security rather than as an HTM security. We'll illustrate the fair value option when we discuss trading securities.
4 GAAP [FASB ASC 320–10–25–6: Investments–Debt and Equity Securities–Overall–Recognition, previously SFAS No. 115 ] lists major unforeseen events that could justify sale of an HTM investment. Sale for other reasons could call into question whether the company actually had the intent and ability to hold the investment to maturity. In that case, the company’s HTM classifi cation is viewed as “tainted,” and the company can be required to reclassify all of its HTM investments as AFS investments and avoid using the HTM classifi cation for two years. Similar provisions exist under IFRS for public companies.